The S&P 500's 5 Most Hated Stocks

Don't let last week's dip in the broad-based S&P 500 fool you -- it's been kicking butt and taking names for five years, and it trudged to yet another all-time record close last week.

A number of factors have been consistently working in favor of the S&P 500, including a steady or dropping unemployment rate, an improved housing market, the persistence of historically low lending rates -- which is spurring refinancing of debt and business expansion -- and a huge improvement in overall banking liquidity to help the U.S. economy weather another crisis.

Yet despite these factors, quite a few gray clouds continue to loom. As a skeptic myself, I've pointed out a number of times that cost-cutting and share repurchases are driving a majority of supposed growth within the S&P 500. In addition, the drawdown of the Federal Reserve's economic stimulus, known as QE3, could rock the housing sector, as consumers have proven to be notoriously fickle about their purchasing habits. Even the falling unemployment rate comes with an asterisk, given that the labor participation rate has fallen sharply for years. In other words, the number of nonfarm jobs today is equal to the number we had roughly five years ago. And, to add insult to injury, many supposedly educated investors don't understand basic investing principles.

Keeping these concerns in mind, I suggest we do what we do every month: take a deeper dive into the S&P 500's five most hated stocks. Why, you ask? Because this way we can better understand what characteristics, if any, attract short-sellers so that we can avoid buying similar companies in the future.

It's been months upon months, but the general thesis about betting against iron-ore miner Cliffs Natural Resources hasn't changed. Skeptics are counting on iron-ore prices to stay down, which has the potential to cripple Cliffs' margins and potentially even threaten its dividend, which was cut by three-quarters last year. Further working against Cliffs is the fact that it got booted from the S&P 500 last week and replaced by Essex Property Trust. Index funds are required to sell shares of Cliffs by default, which added even more downward pressure to the stock.

Source: Cliffs Natural Resources

Is this short interest warranted?

As much as I'm a fan of Cliffs Natural Resources, as I've stated in previous months, I do have to concede that the recent drop in iron-ore prices has the potential to push Cliffs Natural into the red if prices continue to fall. I certainly wouldn't overreact as a shareholder, because these lower iron-ore prices may be passed down the line, actually improving steel demand. With Cliffs drastically reducing costs by putting off its chromite project for later and paying out less in dividends I believe it's positioned to ride out this storm like a champ. That doesn't mean there won't be bumps in the road, but there's not a lot of downside left in this stock in my opinion.

GameStop Why are investors shorting GameStop?

Short-sellers are lining up to bet against brick-and-mortar video game and accessories chain GameStop because they believe in "buy the rumor, sell the news." Leading up to late 2013, GameStop had been running higher in anticipation of the first new gaming consoles in six years coming to market. But shortly after they hit the market, GameStop's holiday season sales missed the mark and sent the stock screaming lower. Further, skeptics believe that as gaming pushes into digital platforms, brick-and-mortar stores like GameStop will be left in the dust.

Is this short interest warranted?

Although GameStop's full-year forecast in late March was rosier than expected, and its cash flow remains impressive, I'm still skeptical of the company at its current valuation. In late March, GameStop forecast 2014 EPS growth of 13%-23%, which was well ahead of Street expectations. But I would contend that its current same-store sales comparisons will be veritably impossible to match beginning in the second-half of this year. We have to remember that this is a highly cyclical and commoditized industry where margins are already razor thin and unlikely to improve for a significant length of time. Even with GameStop pushing into digital gaming, that's still not a big enough component of the company's revenue to make much of a difference. Short-sellers look to have a big bull's-eye on GameStop shares.

U.S. Steel Why are investors shorting U.S. Steel

A lot of the same concerns echoed with Cliffs Natural are apparent with U.S. Steel in that erratic global demand for steel coupled with weakening prices are making it difficult for the company to execute its turnaround. U.S. Steel has dramatically reduced its output in order to cut expenses and help pricing, but its multiple years of losses prove that it's not a simple fix. Pessimists are counting on its recent run higher being deflated as weaker prices lead to softer-than-expected guidance in the upcoming quarter.

Is this short interest warranted?

While I'm still of the opinion that the worst is in the rearview mirror for U.S. Steel, I'm not a big fan of its current valuation. My biggest concern with U.S. Steel remains its net debt, which has been reduced but still sits at a daunting $3.3 billion. Another worry that has to be at the back of investors' minds is whether or not foreign steel sources are going to take a bite into U.S. Steel's domestic demand. Given its huge run over the past year there are simply far too many variables that are working against U.S. Steel, which makes it a company you can easily pass up right now.

Joy Global Why are investors shorting Joy Global?

OK, I get it, no one likes the mining and commodity sectors! Joy Global, a manufacturer of mining equipment, becomes the third company among the four most short-sold stocks in the S&P 500 that's commodity-based. The skeptics' thesis is that weaker commodity prices (i.e., gold, silver, copper, and iron ore) are disincentivizing miners from producing more, thus reducing their want for new equipment. We saw this translate directly into Joy Global's first quarter results, which pointed to a 27% year-over-year decline in net sales and a miserable 16% drop in bookings.

Is this short interest warranted?

I certainly am not going to make excuses for Joy Global with sales down 27%. With commodity prices down this is the year that Joy Global is going to take a spanking, so to speak. What shareholders should keep in mind is that Joy Global is a well-run company that's also going to benefit in a big way when commodity prices stabilize. Note that I said stabilize, not necessarily go up. Miners are simply looking for a reason to boost production, and even an abatement to the downside in underlying commodity prices could be enough. In the meantime, with two consecutive quarterly EPS misses under its belt and revenue expected to dip 25% in fiscal 2014 I would probably expect Joy's upside to be limited.

Many of the same negative points that have worked against Frontier in the past are the primary reason it rounds out the top five most short-sold stocks once again. Frontier has seen a slower but still negative rate of rural landline customer growth, as rural customers are steadily canceling their lines, putting pressure on Frontier's margins. Although the company has been adding broadband customers, its landlines offer a much juicier margin. Skeptics also believe that Frontier's dividend is unsustainable over the long run, expecting that it will be lowered due to a consumer landline exodus or infrastructure upgrade expenses.

Source: Frontier Communications.

Is this short interest warranted?

While I do understand where short-sellers are coming from, Frontier's cash flow remains strong enough each and every quarter to sustain its dividend, yet pessimists don't seem to be catching on. In fact, it's quite plausible that Frontier's recent run-up is based almost entirely on short-covering. Although Frontier hasn't completely stopped its landline losses, they are now practically negligible, all while broadband growth appears to be picking up the slack. At 22 times forward earnings, even I'm not a fan of Frontier, but its 7% yield and high short interest would certainly keep me from betting against it as well.

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Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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